Penny v. The Queen, 95 DTC 5083, [1995] 1 CTC 114 (FCTD)

Simpson J.:-The issue is whether Mr. Winston Penny, as a shareholder of a company, appropriated to himself an account receivable which was payable to the company. If he did so, the amount or value of that asset will be included in the computation of his income for 1981 pursuant to paragraph 15(1)(b) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act”). This issue comes before me as an appeal by Mr. Penny by way of trial de novo from a decision of Taylor J.T.C.C. dated December 18, 1990 in which he held that an appropriation had been made.

The The facts

From 1974 to 1979, Mr. Penny was a principal shareholder of Canada Tube Co. (’’Canada Tube”). It was engaged in the manufacture and sale of steel tubing. In 1979, Mr. Penny sold his 50 per cent interest to his partner Brian Pinkney and agreed not to compete in the steel tube manufacturing business for a two year period which expired on April 13, 1981 (the ”non-competition agreement”). However, in that two year period, Mr. Penny undertook to sell Canada Tube’s manufactured product. For this purpose, a commission sales agreement was entered into between Canada Tube and a company called Bolton Steel Sales Ltd. ("Bolton Sales"). Although Bolton Sales was owned by Mr. Penny and his wife, the evidence was clear that Mr. Penny ran Bolton Sales and that Mr. Penny and Bolton Sales were "synonymous". By April 13, 1981, Canada Tube owed Bolton Sales commissions in the amount of $336,684.96 (the "Bolton Sales receivable").

In the Fall of 1980, Mr. Penny was considering various means of returning to the steel tubing manufacturing business on the expiry of the non-competition agreement. At that time, he became aware that Canada Tube was in serious financial trouble. It could not meet its obligations to its mortgagee the Permanent Commercial (1980) Ltd. ("the Permanent") and it could not pay to Bolton Sales the amount herein described as the Bolton Sales receivable. Mr. Penny therefore decided to return to the steel tube manufacturing business by acquiring Canada Tube’s assets.

The acquisition was a torturous process which involved several early purchase agreements which were executed but not performed. Ultimately, an agreement of purchase and sale (the "asset purchase agreement") was signed. It was dated March 30, 1981 and it provided for the purchase of Canada Tube’s assets, including its two steel tube manufacturing mills, for $2,100,000. The purchasers were Mr. Penny, Bolton Sales and Mr. Penny in trust for a company to be formed. That new company was incorporated as Bolton Steel Tube Co. Ltd. ("Bolton Tube") and, by reason of a later trust agreement, Bolton Tube was recognized as the sole purchaser of Canada Tube’s assets. Although the asset purchase agreement does not refer to the Bolton Sales receivable, the evidence was clear that, as part of the consideration for the purchase, Bolton Tube agreed to assume Canada Tube’s liability to pay to Bolton Sales the amount known as the Bolton Sales receivable.

Bolton Tube had three principal shareholders. Mr. Penny owned one share, a Mr. Fetting, who is now deceased, held one share and a Mrs. Koury owned the third share. She was inactive in the company’s affairs. Mr. Fetting supervised the activities in the shop and Mr. Penny bought the raw steel and sold Bolton Tube’s manufactured steel tubing.

The asset agreement purchase had provided that April 13, 1981 was to be the closing date. However, although Mr. Penny took possession of Canada Tube’s assets and began operating the business on Bolton Tube’s behalf on that day, the formal closing did not occur until October 15, 1981. Accordingly, the statement of adjustments calculated as of April 13, 1981, was not prepared until October 31, 1981. Mr. Koury, who was the lawyer for both Mr. Penny and for Bolton Tube and Bolton Sales, testified that the statement of adjustment was prepared by him on the instructions of Mr. Penny and "maybe the accountants". In connection with the Bolton Sales receivable, it reads "Credit sales contract, Bolton Steel Sales: Amount owing as at Nov. 30: 322,422.17". Mr. Koury testified that this entry accurately reflects Bolton Tube’s understanding that the Bolton Sales receivable was to be paid to Bolton Sales. I do not agree. As it is a statement of adjustments, it indicates that the purchaser is credited with having assumed the liability. In my view, the statement of adjustments does not provide conclusive evidence of the identity of the future payee.

At this point, it becomes instructive to consider what accounting and legal services were available to Mr. Penny during the acquisition of Canada Tube’s assets. It is also useful to note how the books and records of Bolton Tube treated the Bolton Sales receivable.

Mr. Penny’s personal accountant prior to and during the period of the acquisition was a Mr. Damien Leonard ("Leonard"). Mr. Penny testified that Leonard’s involvement in the acquisition consisted of tax planning and the preparation of Bolton Tube’s business plans. Leonard apparently hoped to become a shareholder in Bolton Tube but, as of Bolton Tube’s incorporation which was effective on April 1, 1981, Leonard had not raised the funds required for his capital contribution. Accordingly, he never became a director or shareholder of Bolton Tube, but he continued as Mr. Penny’s personal accountant. As well, from late 1981 or early 1982, he served as Bolton Tube’s in-house accountant. Leonard did not testify at trial. He had a "falling out" with Mr. Penny and has since disappeared.

Although Bolton Tube was incorporated as of April 1, 1981, its books and records were not created until sometime in mid-May 1981. This was about one month after Bolton Tube took possession of Canada Tube’s assets and began its operations. Mr. Koury’s accounting firm of Wagman Ross and Teachman (WR&T") was retained to set up Bolton Tube’s books of account.

In an entry on a page headed September 30, 1981, Bolton Tube’s books record a shareholder’s loan to Mr. Penny of $366,684.96. This is the amount of the Bolton Sales receivable. Mr. Penny testified that there was no such loan and that the entry in fact dealt with the Bolton Sales receivable. He testified that an error had been made by WR&T and that the sum should have been shown as payable to Bolton Sales and not to him personally. This entry will be referred to as the "accounting error". Mr. Penny further testified that he did not see this entry in 1981. According to Mr. Penny, this accounting error is the cause of all the misdescriptions which indicated that the Bolton Sales receivable was payable to Mr. Penny and, arguably, that it had been appropriated by him.

The Bolton Sales receivable was shown as payable to Mr. Penny personally, in the following documents:

1) In an agreement dated April 1, 1981, which contemplated a sale by Mr. Penny to Bolton Tube of Canada Tube’s McKay Mill. This agreement predated the accounting error. It was never performed but it was signed by Mr. Penny and it provided that Bolton Tube would pay the Bolton Sales receivable to Mr. Penny personally. Mr. Penny testified that, in this document and elsewhere, the amount of the Bolton Tube Receivable was rounded up to $350,000.

(ii) In a letter from the Permanent dated May 4, 1981 which dealt with possible terms for its approval of Bolton Tube’s acquisition of Canada Tube. In this letter, which also predates the Accounting Error, the Bolton Sales receivable is described as Mr. Penny’s asset. This was formally acknowledged by Mr. Penny when he signed the Permanent’s letter of June 1, 1981.

(iii) In Bolton Tube’s interim financial statements prepared by WR&T, to May 31, 1981 and to September 30, 1981 and in the interim statements prepared by Doane Raymond to February 28, 1982. These statements were all seen by Mr. Penny and one is signed with his approval on behalf of the Board of Directors. The statements either show the Bolton Sales receivable as payable to Mr. Penny or record a shareholder’s loan in the amount of the Bolton Sales receivable payable to Mr. Penny with interest at 15 per cent. For example, the May 31, 1981 interim statement at note 2 speaks of Canada Tube as the vendor and reads in part:

The purchase transaction has not yet been finalized, although the company has commenced operation of the plant. The balance due on closing will be paid by a cash contribution of $100,000 from Hans Fetting, and by the application of a $350,000 loan receivable from the vendor to Winston Penny.

(iv) In Bolton Tube’s income tax returns for 1982 and 1983. They are signed by Mr. Penny as Bolton Tube’s President and include its audited financial statements for 1982 and 1983. They show that Bolton Tube owed the Bolton Sales receivable to Mr. Penny personally.

(v) In a cheque dated February 16, 1983 which was issued to Winston Penny by Bolton Tube. The amount of the cheque included a payment to Mr. Penny by Bolton Tube of the Bolton Sales receivable. Mr. Penny endorsed the cheque to his personal investment company and deposited it to that company’s credit and not to the credit of Bolton Sales. Thereafter, the money was returned to Bolton Tube and preferred shares of Bolton Tube were issued to Mr. Penny’s personal investment company.

(vi) In the personal income tax return signed by Mr. Penny for 1981. It indicates that Mr. Penny received interest income from Bolton Tube with respect to the Bolton Sales receivable. The evidence also shows that the interest calculations on the Bolton Sales receivable were made as of April 13, 1981. It is worth noting that at this time Bolton Sales did not report the Bolton Sales receivable as income as it ought to have done. This was resolved by a Revenue Canada Assessment to which Bolton Sales ultimately took no objection.

The alleged WR&T accounting error was corrected in late 1983 when the preferred shares in Bolton Tube which had been issued to Mr. Penny’s investment company were cancelled and reissued to Bolton Sales. Mr. Penny was "not sure" whether this correction followed Revenue Canada’s audit. When Bolton Tube redeemed the shares in 1985, Bolton Sales finally received payment of the Bolton Sales receivable.

The taxpayer's position

The books and records of Bolton Tube show that, as of April 13, 1981, Bolton Tube was obliged to pay the Bolton Sales receivable to Mr. Penny personally. However, Mr. Penny said this was all the result of errors which flowed from WR&T’s accounting error. He also said that he never made any formal or indeed informal agreement with Bolton Sales to transfer the Bolton Sales receivable to himself. He added that he never addressed the issue of the appropriate payee as his focus was on the development of Bolton Tube’s business in the difficult pre-closing period when it was carrying on business using premises and assets it did not yet own. He also stressed that he was not involved in Bolton Tube’s bookkeeping or accounting and that he is not educated in such matters having concluded his formal education at grade six. Further, Mr. Penny submits that there can be no appropriation since the Bolton Sales receivable had no value in 1981. This was because Bolton Tube could not have paid the Bolton Sales receivable to anyone in that year. It had insufficient funds and was constrained by bank postponement agreements.

Conclusions

The relevant section of the Act reads:

15. Appropriation of property to shareholder-

(1) Where in a taxation year

(b) funds or property of a corporation have been appropriated in any manner whatever to, or for the benefit of, a shareholder, or

(g) by an action described in paragraph 84(1 )(c. 1) or (c.2)

the amount or value thereof shall, except to the extent that it is deemed to be a dividend by section 84, be included in computing the income of the shareholder for the year.

I have concluded that an appropriation of the Bolton Sales receivable by Mr. Penny under this section did occur as of April 13, 1981 as alleged by the Minister. The appropriation was not, in my view, the result of the accounting error on the part of WR&T. Agreements and correspondence which predate WR&T’s retainer make it plain that Mr. Penny and his legal advisor treated the Bolton Sales receivable as an amount to be paid to Mr. Penny. In addition, Mr. Penny’s personal tax return for 1981 prepared by Leonard, who had been involved in the planning of Bolton Tube, reflects Mr. Penny’s treatment of the Bolton Sales receivable as his own asset at a time when Bolton Sales did not report it as income.

In my view, the word "appropriate" as used in paragraph 15(1)(b) of the Act conveys a notion of taking but does not necessarily require a formal documented taking. Indeed, in circumstances such as those present in this case, where Mr. Penny "was" Bolton Sales, such formalities would not be expected.

I have concluded as well that "appropriation" as used in paragraph 15( 1 )(b) of the Act requires intention and cannot be inadvertent. However, Mr. Penny saw the relevant documents and signed many of them. They stated repeatedly that the Bolton Sales receivable was payable to him. The financial documents were clear. There were only two shareholders loans in Mr. Penny’s account and they bore different rates of interest. Accordingly, the Bolton Sales receivable was easily identified when it was shown as being payable to Mr. Penny personally. Mr. Penny had legal advice from Mr. Koury before and after April 13, 1981. He also had personal and corporate financial advice from Leonard in the period prior to the appropriation which, in my view, occurred as of April 13, 1981. In addition, he received Leonard’s continuing assistance with his 1981 personal income tax return. In these circumstances, I am not prepared to conclude that Mr. Penny was unaware that the Bolton Sales receivable was, for all practical purposes, payable to him.

I have also concluded that the Bolton Sales receivable was the "property” of Bolton Sales. The fact that it was an asset that could not have been realized in 1981 is not a bar to appropriation. Section 15 speaks of including the value or amount in income (my emphasis). This language suggests to me that appropriated property need not be cash or be capable of being converted into cash. As no evidence was adduced on the question of the actual value of the Bolton Sales receivable in 1981, its value must be its face value on April 13, 1981 of $336,684.95.

It is argued that I ought not to find an appropriation because, if I do so, Bolton Sales will have paid tax on the Bolton Sales receivable further to an assessment and Mr. Penny will also pay tax by reason of the inclusion of the Bolton Sales receivable in his income in 1981. It is argued that such double taxation could not have been intended by the legislature. However, it seems to me that, in the case of an appropriation of corporate property by a shareholder, the tax consequences to the shareholder are unambiguous. They are clearly set forth in section 15 of the Act. In these circumstances, I am satisfied that Parliament must have intended the tax consequences which flow from the operation of the section.

The question remains whether the appropriation must be of a legally enforceable right. Mr. Penny says that he could not have sued personally for payment of the Bolton Sales receivable in view of the commission agreement which made it payable to Bolton Sales. This submission is correct but, given the wording of section 15, it is beside the point. The section applies if the shareholder appropriates "in any manner”. To me, this language encompasses a de facto taking. As long as the shareholder derives a benefit, the legality of the appropriation matters not.

The Bolton Sales receivable was undoubtedly appropriated for Mr. Penny’s benefit. In 1981, he received and reported interest paid to him by Bolton Tube on the amount of the Bolton Sales receivable. But for the appropriation, he would have not been entitled to this tangible benefit. In reaching this conclusion, I have relied on the Ontario Court of Appeal’s decision in The Queen v. Poynton, [1972] C.T.C. 411, D.T.C. 6329, in which the Court held that use of benefits from the receivable was a sufficient basis to find an appropriation under section 15 of the Act even when property in the receivable remained with the company. It seems to me that the receipt of interest provides a strong indication that the underlying receivable has been appropriated by the recipient of the interest. In this case, the fact that Mr. Penny actually received payment of the Bolton Sales receivable at a later date testifies to the effectiveness of his appropriation not just of the interest but of the underlying asset.

There was a second benefit to Mr. Penny. In addition to the receipt of the interest, he was able to show his apparent entitlement to the Bolton Sales receivable as part of his contribution to the acquisition of Canada Tube’s assets. Presumably, this enhanced his attractiveness as a prospective purchaser in the eyes of the Permanent.

Finally, there is a question about whether Mr. Penny had to take some direct action to effect the appropriation. In Robinson v. M.N.R., [1993] 1 C.T.C. 2406, D.T.C. 254 (T.C.C.) the Court held that, in a situation where the taxpayer was an "unwilling and uninformed" beneficiary of a benefit, subsection 15(1) of the Act requires some form of action with a strong component of intent to support an appropriation. However, since I have concluded that Mr. Penny was neither unwilling nor uninformed, the Robinson case does not apply.

For all these reasons, the appeal is dismissed.

Appeal dismissed.